Option Trading | Market Decline Ahead – But This Is Not the Big One

Posted 9:30 AM ET – Yesterday the market staged a nasty reversal off of the all-time high. Stocks surged on the open and they were not able to advance. Good news from Facebook was not enough to fuel the rally. This morning we are seeing follow-through selling as bullish speculators get flushed out.

My comments yesterday included these quotes:

“Bullish sentiment is running high and speculators will be flushed out soon.”

“The rally will stall and then with each passing day the risk of a pullback will increase.”

“We made great money during this run and I’m going to lock in profits.”

We sold into strength yesterday morning and we raised our stop on our QQQ calls. I enjoy watching a storm roll in when I am out of harm’s way. We are flat and we are ready to pounce in the next opportunity.

The decline yesterday happened for number of reasons. Bullish sentiment was extremely high and weak hands needed to be flushed out. Mega cap tech stocks were pricing in good news and most were not able to live up to lofty expectations. The FOMC statement was fairly hawkish and investors are nervous about future tightening. The “skinny” healthcare bill did not pass and politicians vacation while the work piles up.

I still believe it’s too early to short this market on a swing trading basis. Stocks will probe for support and they will tread water for a few more weeks as earnings season continues. Towards the middle of August we will see profit-taking. Swing traders need to patiently wait on the sidelines. The warning signs are present and I believe the next move is lower.

Day traders can favor the short side today. Key support levels are SPY $246, $245 and $243. QQQ support levels are $143.50 and $142.50. Any early rally will represent a shorting opportunity. We could hit an air pocket and that low is likely to hold. The backdrop is not particularly bullish or bearish. I believe that this is a flush out. Once bullish speculators have “puked” their positions the market will find support. Any bulls tempted to weather the storm will face pain.

These days typically take one of two paths. The first is a very steady drip lower the entire day and a nice rebound in the last hour. The second is a quick deep drop and a bounce after two hours. Eventually that bounce stalls and the market takes out the low of the day. The second scenario is more bearish and the selling momentum can gather steam into the weekend.

As always, use the first hour range as your guide and pay close attention to the support levels I’ve outlined. This wave of selling should run its course in a couple of days. The more damaging decline is still a few weeks away...

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